PU2: Business Studies Chapter 9 Solutions

PU 2

Chapter 9 Financial Management

Part - A

1. What is Business Finance?

Ans. Money required for carrying out business activities is called business finance.

2. State the primary objective/aim of financial management.

Ans.  The primary objective/aim of financial management is to maximise shareholders’ wealth, also referred to as the wealth-maximisation concept.

3. What do you understand by ‘Capital Structure’?

Ans. Capital structure refers to the mix between owners funds (equity) and borrowed funds (debt).

 

4. Write the meaning of ‘Financial Risk’.

Ans. Financial risk is the chance that a firm would fail to meet its payment obligations.

5. Give an example for fixed asset.

Ans. plant and machinery,

Also

2. furniture and fixture,

3. land and building,

4.vehicles, etc.

(any one can be written)

6. Give an example for current asset.

Ans. inventories,

Also

2. debtors,

3. bills receivables, etc.

(any one can be written)

7. How do you calculate Net Working Capital?

Ans. Net working capital is calculated as the excess of current assets over current liabilities.

 NWC = CA – CL

(i.e. Net working capital =Current Assets - Current Liabilities.)

8. The cheapest source of finance is

(a) Debenture

(b) Equity share capital

(c) Preference share

(d) Retained earnings

Ans. (a) Debenture

Note: debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper.

9. The decision of acquiring a new machine or opening a new branch is an example for

(a) Financing decision

(b) Working capital decision

(c) Investment decision

(d) None of the above

Ans. (c) Investment decision

Note: This is a capital budgeting decision, which is one type of Investment decision.

10. The decision of how much to be raised from which source is an example for

(a) Financing decision

(b) Working capital decision

(c) Investment decision

(d) None of the above

Ans. (d) None of the above

Note: Financing Decision is about the quantum of finance to be raised from various long-term sources. Short-term sources are studied under the ‘working capital management’. Since, the question does not specify what type of source, so the answer is (d).

11. Companies with higher growth pattern are likely

(a) to pay lower dividends

(b) to pay higher dividends

(c) that dividends are not affected by growth issues

(d) none of the above

Ans. (a) to pay lower dividends

12. Current assets are those assets which get converted into cash

(a) within six months

(b) within one year

(c) between 1 and 3 years

(d) between 3 and 5 years

Ans. (b) within one year

13. A fixed asset should be financed through

(a) a long term liability

(b) a short term liability

(c) a mix of long and short term liabilities

(d) None of the above

Ans. (a) a long term liability

Part - B

14. What do understand by Financial Management?

Ans. Financial Management refers to all the activities of an organisation undertaken with the aims at mobilisation of financial resources at a lower cost and deployment of these in most lucrative activities. Thus, Financial Management aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.

15. Give the meaning Investment Decision with an example.

Ans. The investment decision relates to how the firm’s funds are invested in different assets.

Investment decision are of two types:

1.  long-term investment decision (also called Capital budgeting decisions). For example: making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc. (any one example can be written)

2.  short-term investment decisions also called working capital decisions). For example: decisions about the levels of cash, inventory and receivables.

 

16. What is Financing Decision? Give an example.

Ans. Financing Decision is about the quantum of finance to be raised from various long-term sources. It determines the overall cost of capital and the financial risk of the enterprise. It involves

1. identification of available sources (i.e shareholder’s funds and borrowed funds) and

2. proportion of funds to be raised from these sources, based on their basic characteristics.

17. Give the meaning of Dividend Decision.

Ans. Dividend Decision is concerned with deciding how much of the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business.

18. State the twin objectives of Financial Planning.

Ans.  The twin objectives of Financial Planning are:

(a). To ensure availability of funds whenever required

(b). To see that the firm does not raise resources unnecessarily

19. What is Financial Leverage? Write the formula to calculate Financial Leverage.

Ans. The proportion of debt in the overall capital is called financial leverage. Financial leverage is computed as D / E or D / (D+E) when D is the Debt and E is the Equity.

20. Give the meaning of ‘Trading on Equity’.

Ans. Trading on equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. In other words, the practice employed by companies to have more of cheaper debt to enhance the EPS is called Trading on equity.

21. Write the formula to calculate Debt Service Coverage Ratio.

Ans. By calculating Debt Service Coverage Ratio, the cash profits generated by the operations are compared with the total cash required for the service of the debt and the preference share capital. It is calculated as follows:

(Profit after tax + Depreciation + Interest + Non Cash exp.) / (Pref. Div + Interest + Repayment obligation)

Part - C

22. Explain any four factors affecting financing decisions.

Ans. Meaning of Financing Decisions: Refer to Q 16.

Factors Affecting Financing Decisions are:

(a). Cost: The cost of raising funds through different sources are different. A prudent financial manager would normally opt for a source which is the cheapest.

(b). Risk: The risk associated with each of the sources is different.

(c). Floatation Costs: Higher the floatation cost, less attractive the source.

(d). Cash Flow Position of the Company:A stronger cash flow position may make debt financing more viable than funding through equity.

Also

(e). Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more debt financing may be preferred.

(f). Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.

(g). State of Capital Market: Health of the capital market may also affect the choice of source of fund. During the period when the stock market is rising, more people invest in equity. However, a depressed capital market may make issues of equity shares difficult for any company.

(any four can be written).

23. Explain any four factors affecting dividend decisions.

Ans. Meaning of dividend decision – Refer to Q 17

Factors Affecting Dividend Decision are:

(a). Amount of Earnings: As dividends are paid out of current and past earning, earnings is a major determinant of the decision about dividend.

(b). Stability of Earnings: Other things remaining the same, a company having stable earnings is in a better position to declare higher dividends. As against this, a company having unstable earnings is likely to pay a smaller dividend.

(c). Stability of Dividends: Companies generally follow a policy of stabilising dividend per share. The increase in dividends is generally made when there is confidence that their earning potential has gone up and not just the earnings of the current year.

(d). Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies is, therefore, smaller, than that in the non–growth companies.

Also

(e). Cash Flow Position: The payment of dividend involves an outflow of cash. A company may be earning profit but may be short on cash. Availability of enough cash in the company is necessary for declaration of dividend.

(f). Shareholders’ Preference: If the shareholders in general desire that at least a certain amount is paid as dividend, the companies are likely to declare the same.

(g). Taxation Policy: The choice between the payment of dividend and retaining the earnings is, to some extent, affected by the difference in the tax treatment of dividends and capital gains. If tax on dividend is higher, it is better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower. Though the dividends are free of tax in the hands of shareholders, a dividend distribution tax is levied on companies. Thus, under the present tax policy, shareholders are likely to prefer higher dividends.

(h). Stock Market Reaction: Investors, in general, view an increase in dividend as a good news and stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market. Thus, the possible impact of dividend policy on the equity share price is one of the important factors considered by the management while taking a decision about it.

(i). Access to Capital Market: Large and reputed companies generally have easy access to the capital market and, therefore, may depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

(j). Legal Constraints: Certain provisions of the Companies Act place restrictions on payouts as dividend. Such provisions must be adhered to while declaring the dividend.

(k). Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividend does not violate the terms of the loan agreement in this regard.

(any four can be written)

24. What is Capital Budgeting decision? Explain briefly the factors affecting capital budgeting decisions.

Ans. A long-term investment decision is called a Capital Budgeting decision. It involves committing the finance on a long-term basis. For example, making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc.

Factors affecting Capital Budgeting Decision are:

(a). Cash flows of the project: When a company makes an investment decision involving a huge amount it expects to generate some cash flows over a period. These cash flows are in the form of a series of cash receipts and payments over the life of an investment. The amount of these cash flows should be carefully analysed before considering a capital budgeting decision.

(b). The rate of return: The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and the assessment of the risk involved. Suppose, there are two projects, A and B (with the same risk involved), with a rate of return of 10 per cent and 12 per cent, respectively, then under normal circumstances, project B should be selected.

(c). The investment criteria involved: The decision to invest in a particular project involves a number of calculations regarding the amount of investment, interest rate, cash flows and rate of return. There are different techniques to evaluate investment proposals which are known as capital budgeting techniques. These techniques are applied to each proposal before selecting a particular project.

 

25. Explain with any four points the importance of financial planning.

Ans. Meaning of financial planning - The process of estimating the fund requirement of a business and specifying the sources of funds is called financial planning. Thus, financial planning seeks to achieve a proper match of funds requirements and their availability.

Importance of financial planning

(i). It helps in forecasting what may happen in future under different business situations. By doing so, it makes the firm better prepared to face the future. For example, a growth of 20% in sales is predicted. However, it may happen that the growth rate eventually turns out to be 10% or 30%. Many items of expenses shall be different in these three situations. By preparing a blueprint of these three situations the management may decide what must be done in each of these situations.

(ii). It helps in avoiding business shocks and surprises and helps the company in preparing for the future.

(iii). It helps in coordinating various business functions, e.g., sales and production functions, by providing clear policies and procedures.

(iv). Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.

Also

(v). It tries to link the present with the future.

(vi). It provides a link between investment and financing decisions on a continuous basis.

(vii). By spelling out detailed objectives for various business segments, it makes the evaluation of actual performance easier.

(any four can be written)

26. Explain any four factors affecting the fixed capital requirement of an organisation.

Ans. Meaning of fixed capital - Fixed capital refers to investment in long-term assets.

Factors affecting the requirement of Fixed capital are -

1. Nature of business: The type of business has a bearing upon the fixed capital requirements. For example, a trading concern needs lower investment in fixed assets compared with a manufacturing organisation; since it does not require to purchase plants and machinery, etc.

2. Scale of Operations: A larger organisation operating at a higher scale needs a bigger plant, more space etc. and therefore, requires higher investment in fixed assets when compared with the small organisation.

3. Choice of technique: Some organisations are capital intensive whereas others are labour intensive. A capital-intensive organisation requires higher investment in plant and machinery as it relies less on manual labour. The requirement of fixed capital for such organisations would be higher. Labour intensive organisations on the other hand require less investment in fixed assets. Hence, their fixed capital requirement is lower.

4. Technology Upgradation: In certain industries, assets become obsolete sooner. Consequently, their replacements become due faster. Higher investment in fixed assets may, therefore, be required in such cases. For example, computers become obsolete faster and are replaced much sooner than say, furniture. Thus, such organisations which use assets which are prone to obsolescence require higher fixed capital to purchase such assets.

Also

5. Growth Prospects: Higher growth of an organisation generally requires higher investment in fixed assets. Even when such growth is expected, a company may choose to create higher capacity in order to meet the anticipated higher demand quicker. This entails larger investment in fixed assets and consequently larger fixed capital.

6. Diversification: A firm may choose to diversify its operations for various reasons, With diversification, fixed capital requirements increase e.g., a textile company is diversifying and starting a cement manufacturing plant. Obviously, its investment in fixed capital will increase.

7. Financing alternatives: A developed financial market may provide leasing facilities as an alternative to outright purchase. When an asset is taken on lease, the firm pays lease rentals and uses it. By doing so, it avoids huge sums required to purchase it. Availability of leasing facilities, thus, may reduce the funds required to be invested in fixed assets, thereby reducing the fixed capital requirements. Such a strategy is specially suitable in high risk lines of business.

8. Level of collaboration: At times, certain business organisations share each other’s facilities. For example, a bank may use another’s ATM or some of them may jointly establish a particular facility. This is feasible if the scale of operations of each one of them is not sufficient to make full use of the facility. Such collaboration reduces the level of investment in fixed assets for each one of the participating organisations.

(any four can be written)

27. Explain any four factors affecting the working capital requirement of an organisation.

Ans. Meaning of working capital - Apart from the investment in fixed assets every business organisation needs to invest in current assets. Some part of current assets is usually financed through short-term sources, i.e.current liabilities. The rest is financed through long-term sources and is called net working capital. Thus, NWC = CA – CL (i.e. Current Assets - Current Liabilities.)

Factors affecting the working capital requirement of an organisation are -

1. Nature of business: A trading organisation usually needs a smaller amount of working capital compared to a manufacturing organisation. This is because there is usually no processing. In a manufacturing business, however, raw material needs to be converted into finished goods before any sales become possible. Other factors remaining the same, a trading business requires less working capital.

Similarly, service industries which usually do not have to maintain inventory require less working capital.

2. Scale of Operations: For organisations which operate on a higher scale of operation, the quantum of inventory and debtors required is generally high. Such organisations, therefore, require large amounts of working capital as compared to the organisations which operate on a lower scale.

3. Business cycle: Different phases of business cycles affect the requirement of working capital by a firm. In case of a boom, the sales as well as production are likely to be larger and, therefore, a larger amount of working capital is required. As against this, the requirement for working capital will be lower during the period of depression as the sales as well as production will be small.

4. Seasonal Factors: Most businesses have some seasonality in their operations. In peak season, because of higher levels of activity, larger amounts of working capital are required. As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.

Also

5. Production cycle: Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Duration and the length of production cycle, affects the amount of funds required for raw materials and expenses. Consequently, working capital requirement is higher in firms with longer processing cycles and lower in firms with shorter processing cycles.

6. Credit allowed: Different firms allow different credit terms to their customers. These depend upon the level of competition that a firm faces as well as the credit worthiness of their clientele. A liberal credit policy results in a higher amount of debtors, increasing the requirement of working capital.

7. Credit availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent it avails the credit on purchases, the working capital requirement is reduced.

8. Operating efficiency: Firms manage their operations with varied degrees of efficiency. For example, a firm managing its raw materials efficiently may be able to manage with a smaller balance.Such similar efficiencies may reduce the level of raw materials, finished goods and debtors resulting in lower requirement of working capital.

9. Availability of raw material: If the raw materials and other required materials are available freely and continuously, lower stock levels may suffice. In addition, the time lag between the placement of order and the actual receipt of the materials (also called lead time) is also relevant. Larger the lead time, larger the quantity of material to be stored and larger shall be the amount of working capital required.

10. Growth Prospects: If the growth potential of a concern is perceived to be higher, it will require a larger amount of working capital so that it is able to meet higher production and sales targets whenever required.

11. Level of competition: Higher level of competitiveness may necessitate larger stocks of finished goods to meet urgent orders from customers. This increases the working capital requirement. Competition may also force the firm to extend liberal credit terms discussed earlier.

12. Inflation: With rising prices, larger amounts are required even to maintain a constant volume of production and sales. The working capital requirement of a business thus, becomes higher with higher rate of inflation.